Commodity Futures Trading for Beginners

By Bruce Babcock

Commodity Trading as an Investment Vehicle

There are many inherent advantages of commodity futures as an investment vehicle over other
investment alternatives such as savings accounts, stocks, bonds, options, real estate and collectibles.

The primary attraction, of course, is the potential for large profits in a short period of time. The reason
that futures trading can be so profitable is leverage.

For instance, if you had a $10,000 futures trading account, you could trade one S&P 500 stock index
futures contract. If you were going to buy the equivalent amount of common stocks, you would currently need about $350,000, thirty-five times as much.

Let's say you decided that the stock market was going to go up. You could invest $350,000 and buy individual stocks equivalent to the S&P index, or you could buy one S&P futures contract. Buying a futures contract is the same as betting that the S&P index will go up.

If you had made your move on the first trading day of September, 1996 and held your position for two weeks, your common stock position would have been worth about $20,000 more than when you bought it, a gain of about six percent. Not bad for only two weeks. If you had taken the futures route, however, you would have made the same $20,000, which would have been a 200 percent gain on the $10,000 margin required in your futures trading account.

That is an actual example of the tremendous returns you can earn in a short period of time trading futures. Of course, you can lose money just as fast if you trade in the wrong direction. Suppose you had thought the stock market was about to go down and you had sold a futures contract instead of buying one. If you had valiantly held it for two weeks, you would have lost $20,000. That's a good example of why you must exit your trades quickly if they start to move against you.

Another advantage of futures trading is much lower relative commissions. Your commission on that $20,000 futures trading profit would have been only about $30 to $50. Commissions on individual stocks are typically as much as one percent for both buying and selling. That could have been $7,000 to buy and sell a basket of stocks worth $350,000.

While profits can be large in commodity trading, it is not easy to make consistently correct decisions about what and when to buy and sell.

Commodity speculation offers an important advantage over such illiquid vehicles as real estate and collectibles. The balance in your account is always available. If you maintain sufficient margin, you can even spend your current profit on a trade without closing out the position. With stocks, bonds and real estate, you can't spend your gains until you actually sell the investment.

As you will see, commodity trading is not particularly complicated. Unlike the stock market where there are over ten thousand potential stocks and mutual funds, there are only about forty viable futures markets to trade. Those markets cover the gamut of market sectors, however, so you can diversify throughout all important segments of the world economy.

In futures trading, it is as easy to sell (also referred to as going short) as it is to buy (also referred to as going long). By choosing correctly, you can make money whether prices go up or down. Therefore, trading a diversified portfolio of futures markets offers the opportunity to profit from any potential economic scenario. Regardless of whether we have inflation or deflation, boom or depression, hurricanes, droughts, famines or freezes, there is always the potential for profit trading commodities.

There are even tax advantages to making your money from futures trading. Regardless of the actual holding period, commodity profits are automatically taxed as sixty percent long-term capital gains and forty percent short-term capital gains. The current maximum capital gains rate is thirty-three percent, somewhat less than the maximum rate for ordinary income. To the extent that capital gains tax rates are reduced in the future, commodity traders will benefit. If a distinction is re-established so that taxes on long-term gains are lower than on short-term gains, commodity traders will benefit.

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